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State pension fund execs peering through rose-colored glasses

State lawmakers are expected to address the woes of the state’s public pension systems later this year. A recent report indicates they have their work cut out for them. According to the report, published in the Journal of Economic Perspectives by Joshua D. Rauh, an associate professor of finance at the Kellogg School of Management at Northwestern, and Robert Novy-Marx at the University of Chicago, Ohio is in the worst shape of any state when state revenues are projected against pension obligations.

“Ohio faces the largest burden. It would need to devote over eight years of tax revenue solely to retirement funding to cover already-acquired pension liabilities,” the authors report.

An investigation by Ohio’s major daily newspapers in January indicated that the taxpayer bill to cover pension expenses for government retirees could top $5 billion annually in five years. But the Rauh and Novy-Marx’s report says it’s worse than that.

The authors estimate that if proper accounting techniques were used, Ohio’s real pension fund obligation would have been $332.5 billion in December 2008 (at the start of the national economic meltdown), compared with the officially stated liability of $190.9 billion.

The pension systems’ forecasts are based on an “eight percent solution.” Fund executives argue that eight percent is the average return on investment that pension funds should “expect” to see in the future.

Economists claim such a rate is optimistic at best. Jay Greene, chairman of the University of Arkansas’s Department of Education Reform, says relying on eight percent is gambling with taxpayers’ money.

“The issue is that no one can hope to earn more than the risk-free rate of return – the Treasury rate [about 4.625 percent] – without assuming additional risk. Longer time horizons do not eliminate risk,” Greene told the Gadfly. “There is no guarantee that the market return over 30 years will be eight percent annually. And if the actual return falls short it is the taxpayer who is left holding the bag.”

By comparison, the S&P 500 stock index averaged 16.7 percent annual returns in the 1950s, but just 5.2 percent in the 1960s. It declined an average of 1.4 percent a year in the 1970s. For the whole period from 1950 to 2008, the index averaged a 6.8 percent annual return. Accounting procedures for private funds base investment expectations on returns of six percent or less.

Defenders of the pensions' accounting techniques argue that government is special. Unlike corporations, governments have the power to tax to raise pension revenues. That’s cold comfort to Ohio’s taxpayers who may very well be asked to foot the bill. After all, the Buckeye State’s tax rates would have to increase significantly just to pay for the current pension obligations.

The State Teachers Retirement System of Ohio, which, by law, all of the state’s public school teachers belong to, lost 29 percent of its value during the dark days of 2008-09. Rocked by those losses and with its portfolio nowhere near being in compliance with state law, STRS has recommended that lawmakers mandate higher retirement ages for teachers, lower retirement benefits for participants, and higher employee and employer contribution rates.

"If no changes are made we will eventually be unable to pay benefits," STRS Executive Director Michael Nehf told the Ohio Retirement Study Council last September.

Specifically, STRS wants school districts to increase their contribution rates from 14 percent of a teacher’s salary to 16.5 percent over five years, starting in 2016. Under the STRS recommendations, teachers’ contributions to their retirement fund would go up from 10 percent of their paycheck to 12.5 percent.

Local school boards say they can’t shoulder the increase (see editorial above). “School districts are struggling every day for high-quality student achievement. To do what the retirement system suggests, districts have to dig deeper into finances,” said Rob Delane, deputy executive director of the Ohio School Boards Association. And for their part, lawmakers realize that Ohio can’t afford to spend any more on pensions.

Rep. Lynn Wachtmann (R-Napoleon) says it isn’t fair for STRS and other pension funds to be asking for more money from employers, adding, “There is no additional money in any foreseeable [state] budget for years to come.”

Rep. Vernon Sykes, an Akron Democrat and chair of the House finance committee, agrees. “We know we don’t have enough money to continue benefits at the level they are now,” he said.